Predictably, there was panic. The shares that rose last week on hopes there was light at the end of the sovereign debt tunnel fell back again as it became clear that the light was an oncoming train called the Greek referendum express. Markets reacted with horror to the idea that the birthplace of democracy would put the terms of the latest imposed austerity programme to its people.

But was not really just about Greece: it was also about Italy, another southern European government with an unstable government, oodles of debt, low growth and – how shall we put this – a relaxed approach to paying tax. Far more important than the kneejerk response of the equity markets was the sharp increase in Italian 10-year bond yields, a key measure of how expensive it is for the eurozone’s third biggest country to finance its debts. Anything above 6% means the amber warning signs are flashing loud and clear; anything above 7% and Italy joins Greece, Ireland and Portugal in the bailout club.

Conversely, every investor wanted to buy German bonds, a traditional safe haven in times of crisis. And, make no mistake, this is certainly a crisis. The decision by George Papandreou to hold a plebiscite will – assuming the Greek government does not collapse in the meantime – mean at least two months of turmoil as the markets fret about the consequences of a no vote.

You don’t need to be an economic or political genius to work out what the consequences could be: Greece would lose the bailout cash that has enabled the government to pay its bills; the banking system would collapse; the country would default and either leave or be kicked out of the single currency.

That, of course, would not be the end of it. Having picked off the weakest wildebeest at the back of the herd, the markets would look for the next weakest. In some ways the most interesting number yesterday was not from the City but from the bookmaker William Hill: it put the odds on a country leaving the euro by the end of 2012 at 11-10.

There was real confusion on Tuesday night as to whether the referendum would go ahead. Rumours were swirling around Athens that the vote had been scrapped within 24 hours of being called. Papandreou’s days as prime minister were said to be numbered. He was due to be holding talks with Angela Merkel and Nicolas Sarkozy (Wednesday) in order to find a way out of the latest mess the eurozone has found itself in. After struggling to put together last week’s emergency package, it is unlikely the German chancellor and the French president will be in the best of moods.

So why did Papandreou drop his bombshell? And how will events play out?

The answer to the first question is probably a mix of political necessity and some low political cunning. Greece’s economy is shot to pieces; its finances are a disaster; the social cost of an economic collapse made worse by repeated doses of austerity is becoming unbearable.

The protests at the military parades on Sunday to mark Greek opposition to the invasion by Mussolini in 1940 seem to have opened Papandreou’s eyes to the difficulty he is going to have getting public approval for the latest draconian bailout terms. The southern shore of the Mediterranean has already seen popular uprisings this year: the referendum may have been seen as a way of preventing them spreading northwards.

Greece’s street protesters are actually right in their assessment. There is not the remotest possibility of austerity working, because the impact of such savage cuts is to depress the economy, increasing the deficit rather than cutting it, adding to pressure for still further austerity.

The budget deficit this year is likely to be higher than last year’s 10.5%, partly because interest charges are high and rising, and partly because the economy, which has contracted by 15% in the past three years, is still getting smaller. This is not a recovery plan, it is a death spiral.

As Charles Dumas at Lombard Street Research said: “Greece has little chance of fulfilling its austerity-programme targets within the euro. The current approach amounts to ‘pain for pain’s sake’ – punishment.”

Papandreou, however, has two things going for him. The first is that while 60% of Greeks oppose more austerity (and the wonder is that the figure is not higher), 70% say they want to remain in the single currency. The fact that there is no real appetite for having the drachma back means that a referendum could be won. Electorates are notoriously conservative when it comes to plebiscites: they tend to opt for the status quo, and in this instance the status quo would mean swallowing the onerous bailout conditions rather than taking a leap in the dark.

The second card Papandreou has to play is that Greece is now a bigger problem for Europe than Europe is for Greece. The short-term outlook for Greece is going to be bad inside or outside the single currency, but the balance of risks is different for the other 16 members of monetary union. For them, the calculation is simple: would it be better to cut the Greeks some slack in order to prevent a disorderly default creating a domino effect across the eurozone? Or should they take a tough line, threatening to cut off all support in the event of a no vote? That is what is known as a no-brainer.

Why? Because the events of past 24 hours have made much clear: the sovereign debt crisis is getting more serious; the markets will remain turbulent; last week’s rescue package is a dead letter; the chances of a euro breakup have increased.

All this is pretty obvious. What is perhaps less obvious is that Greece now has immense power as a result of its predicament. It has the rest of the world by the short and curlies.